Income Elasticity of Demand
A measure of the responsiveness of demand for changes in income.
Importance of YED for Firms
When there is economic growth, society's income increases leading to a higher demand for goods and services. As we saw in the previous section:
- Demand for goods with a YED less than 1 grows at a smaller rate than income (income inelastic demand).
The goods that have income inelastic demand are:
- Utilities
- Basic food
- Public transportation
Their incomes, as it increases, will become more aligned to expenditure on luxury goods.
- Demand for goods with a YED higher than 1 grows at a higher rate than income (income elastic demand).
The goods that have income elastic demand are:
- Fine Dining (Restaurants)
- Luxury Cars
- High-end technologies
- Vacations
- Therefore, industries with goods and services that are income elastic in demand would expand faster than total income in the economy.
- Those with income inelastic demand would expand slower comparatively.
- This also means that if an economy is facing recession, then goods and services that are income elastic in demand would be most affected negatively.
Hence, firms willing to expand may decide to sell goods and services with high income elasticity, though these come with higher risks as well.
Importance of YED in explaining changes in Sectoral Structure of the Economy
All economies have three sectors:
- Primary Sector (primary commodities)
- Manufacturing Sector (manufactured products)
- Tertiary/Service Sector (services such as education, healthcare, entertainment etc.)
Primary Commodities
Goods and services that directly come from natural resources or using the factor of production called land.
These different sectors have goods and services with different elasticities of income causing them to grow at different rates.
Primary Sector
The primary sector tends to have a low YED (2.5.5). Therefore:
- As incomes rise, the demand for these goods does not grow significantly.
- This limited demand growth indicates why the primary sector’s contribution to GDP and employment declines as economies develop.
Therefore, it is often observed that less developed economies tend to have a higher share of employment and GDP from the primary sector while developed ones have a low proportion.
As a result, firms in the primary sector often face challenges in sustaining revenue growth over time.
Secondary Sector
Manufactured Products
Goods or services produced by the workings of labour, capital and raw materials.
The secondary sector benefits from higher YED values for manufactured goods.
- As incomes rise, consumers demand more durable goods (cars, appliances...) and luxury products (high-end technologies, luxury cars...).
- This makes manufacturing a key driver of economic growth during industrialisation.
Firms in this sector often invest in technology and innovation (research and development) to meet the growing demand.
However, as economies mature, the secondary sector’s growth slows as:
- Consumers eventually saturate their consumption of durable goods and shift spending toward services.
- Hence, presently, many developed economies have a high share of tertiary sector.
Many students assume that manufacturing will always dominate in growing economies. However, in high-income economies, the tertiary sector typically overtakes manufacturing as the primary driver of growth.
Tertiary Sector
The tertiary sector experiences the most significant growth in advanced economies.
- Services like healthcare, education, entertainment, and finance often have high YED values.
- Firms in the tertiary sector thrive by offering differentiated, high-value-added services.
Hence, developed economies have a high share of the service sector.
Challenges of Sectoral Change
Structural Unemployment
As economies transition from one sector to another, workers in declining sectors may lose jobs and struggle to find employment in growing sectors.
Income Inequality
Sectoral change can widen income disparities. Workers in high-growth sectors often earn significantly more than those in declining sectors.
Case studyCase Study: China's Economic Growth and Sectoral Shifts
Context:
In 1978, China implemented economic reforms that transitioned the country from a largely agricultural economy to a global leader in manufacturing and services. These shifts are closely tied to the Income Elasticity of Demand (YED), which explains how changes in income influence demand for different types of goods and services.
Effects of Sectoral Shifts:
Primary Sector: Low YED
- 1978 Contribution: The primary sector (mainly agriculture) accounted for 28% of GDP and employed around 70% of the workforce.
- During the early 1970s, the primary sector had accounted for majority of the GDP. However, there is a lack of data to account for this.
- 2023 Contribution: By 2023, this share had dropped to 7.1%, with less than 25% of the workforce employed in agriculture.
- Key Reasons:
- Low YED for agricultural products: As incomes rose, demand for food and other primary goods grew more slowly compared to manufactured goods and services.
- Urbanisation: Millions of workers moved to cities in search of better-paying jobs, reducing reliance on agriculture.
- Impact: The primary sector's decline reflects its income-inelastic nature, as rising incomes drive demand toward secondary and tertiary goods.
Secondary Sector: Higher YED
- 1978 Contribution: The secondary sector (manufacturing and industry) made up 48% of GDP, attracting workers transitioning from agriculture.
- 2023 Contribution: By 2023, its share had declined to 38.3%, as manufacturing matured and competition from the service sector intensified.
- Key Drivers of Growth:
- High YED for durable goods: Rising incomes led to significant demand for manufactured products such as cars, appliances, and electronics.
- Export-driven growth: China’s position as the "factory of the world" boosted industrial output for global and domestic markets.
- Challenges: As economies mature, demand for manufactured goods slows due to saturation and shifting consumer preferences toward services.
- Impact: The secondary sector demonstrates how income-elastic goods grow rapidly in early development stages but slow as economies evolve.
Tertiary Sector: Highest YED
- 1978 Contribution: The tertiary sector (services) contributed just 24% of GDP and employed a relatively small share of the workforce.
- 2023 Contribution: By 2023, services accounted for 54.6% of GDP, becoming the dominant sector and the largest employer.
- Key Drivers of Growth:
- High YED for services: Rising incomes drove increased spending on healthcare, education, finance, and entertainment.
- Technological innovation: Platforms like Alibaba (e-commerce) and Tencent (digital entertainment) expanded access to services, boosting their share of GDP.
- Impact: The rapid growth of the tertiary sector highlights its strong income elasticity, as consumer spending shifts toward high-value services in advanced economies.
Challenges of Sectoral Change:
- Structural Unemployment:
- As the primary sector shrinks and the tertiary sector expands, many workers lack the skills needed for service-based roles.
- Millions of rural workers migrating to cities faced challenges adapting to urban job markets.
- Income Inequality:
- The rapid growth of urban areas tied to manufacturing and services has widened the income gap between rural and urban populations.
- Workers in declining sectors like agriculture earn significantly less than those in high-growth industries.
- Market Saturation:
- In the secondary sector, saturation of demand for durable goods has slowed growth, forcing firms to innovate or diversify into new industries.
- Companies in the tertiary sector face challenges meeting the diverse and rapidly changing demands of consumers.
To what extent should governments intervene to influence sectoral change? Consider the balance between market forces and state intervention in shaping economic growth.
Self reviewWhat strategies can firms adopt to manage the challenges of sectoral change, such as structural unemployment or environmental concerns?
